Just a breather for global bond markets, or is it really the end of the gravy train?

Monday 12th September 2016

  

Just a breather for global bond markets, or is it really the end of the gravy train?

ref:- "There's a Simple Reason JP Morgan Is Warning Investors to Take Care With US Treasuries", Bloomberg Markets

Great investments ideas that on the face of it seem to make no sense whatsoever, no 184833: 

" Let's buy a bond that, if we hold it to maturity, is guaranteed to be worth less than the amount we paid for it".

That's exactly what you're doing of course if you buy a bond with a negative yield as you might easily do in Japan or Germany, for example. Even in the US and the UK, where yields are positive but almost negligible by historical standards, it seems counter-intuitive to purchase long-term instruments that offer such paltry returns.

It's not that simple of course. Govermment bonds offer the ultimate safe-haven at times of market panic, and we've seen plenty of those ..... the epitome of the "risk-off" trading strategy, if you like. More to the point, just because yields are low and prices high it does NOT mean that yields can't go even lower and prices even higher. In an age where central banks have been repeatedly expanding monetary stimulus, buying bonds has proved enormously profitable. Forget the yield , just watch the capital value of your bond soar.

Of course, monetary easing may have been the norm in most of the world but it's not the case in the US, so why has the Treasury market been so strong when all the talk is of rate hikes? In a way, the question provides it's own answer. The talk may have been hawkish  but has  so far proved to be just that  --  talk.  The inability of the Fed to carry through its rate normalisation process has left a looser monetary environment than expected  -- which of course in terms of market dynamics is bullish for bonds.

So global government bond markets have been on the charge  --  or at least they were until a month or so ago when things started to stall and yields began to inch higher again. Some numbers: the 10yr yield in US Treasuries is close to 1.70% after reaching a low point of 1.35%. The German bund yields 0.19 after a low of 0.04, in Japan it's nudging 0.00 after -0.29 and in the UK gilt yields are touching 0.90 having made a post-Brexit low of 0.51. Looked at in black and white we can see that if it's a breather that the markets are taking, then it's a significant one .... are we looking at something more fundamental?

Unsurprisingly, these markets tend to move together even if the so-called "yield pick-up" trade has often influenced different countries' debt in different directions. The yield pick-up is the profit that foreign investors can earn by selling government bonds in their own countries in local currencies to buy higher-yielding US Treasuries. Now however the yield differential between other bonds and Treasuries has narrowed and the cost of currency-hedging increased, making the pick-up trade a non-runner. The very high correlation coefficient between global bond markets means that where one market leads in reaction to something that may in theory only be relevant to itself, other markets will follow. Just at the moment, and after such an extended rally, the markets are concerned with what might pull the rug out from underneath them.

It's understandable when you think back to the huge market (over)reactions seen in the "Taper Tantrum" of 2013, when then Fed Chairman Ben Bernanke signalled the scaling back (tapering) of the Fed's QE programme. Or the crash in Bunds last year (yields up 0.90%) largely due to fears of a bursting of the bubble. So what is getting them all twitchy this time ? In the UK you could put it down to thoughts that the post-Brexit panic was overdone. In Germany and Japan, it's growing doubts that central banks have the ability (and perhaps the will) to continue with such expansionary monetary policy to boost growth and inflation. Some  think that the ECB's recent decision to hold things as they are signals an inherent reluctance to go further. In Japan, we're not sure anybody is really too certain what BoJ boss Kuroda truly has in mind, except that he is keen to steepen the yield-curve. That means either further supressing short-term yields, or lifting ones at the longer-end (which of course would lower prices).

And the US? Already under pressure as global yields rise, US Treasuries received a substantial knock on Friday when President of the Boston Fed Eric Rodengren said that postponing the next rate hike risked the economy overheating. He thus managed to re-ignite much of the rate hike speculation that had calmed down after the disappointing employment numbers. Look out later today for the speech of Fed committee member Lael Brainard, the last official to speak (hooray!) before communications are closed down ahead of the Fed decision next week. Well-known as an arch dove, if she says anything even remotely hawkish (unlikely) you can expect the markets to take it badly, to say the least.

Oh, one more thing .....

Jittery bond markets are not the ideal conditions to dump a load of new paper on investors, but that's what's on the agenda for later today when the Treasury auctions $44 billion of 3 and 10 year bonds. Ideal or not, the auction promises to be instructive. If there's plenty of demand, nerves should be calmed. If there's not...... well, let's wait and see.